In general, repo transactions are considered to have low credit risk due to the collateral provided.

However, especially when the repo period extends over a longer time, the market value of the underlying collateral, the bond price can fluctuate.

This change in collateral value could result in the collateral no longer fully covering the cash that has been lent, creating credit risk for the cash lender to mitigate this potential credit risk repo transactions typically incorporate two types of margin, initial margin, and variation margin.

The initial margin is an upfront measure applied to ensure that the market value of the security exceeds the amount of cash lent.

This margin is often expressed as a haircut, a percentage reduction from the market value of the collateral.

For example, if a cash lender applies a 2.5% haircut, the amount of cash lent would be slightly less than the collateral's market value, creating a buffer to protect against minor fluctuations in value.

So if the collateral's market value is 100 million dollars, a 2.5% haircuts would allow the cash borrower to borrow $97.5 million against it.

This initial buffer is meant to provide the cash lender with a margin of safety from the start of the transaction.

In addition to the initial margin, repo transactions often use variation margin to account for changes in the collateral's market value over time.

This margin requires that the collaterals value is periodically reassessed, typically once per day, to respond quickly to any changes.

However, to maintain operational efficiency, variation, margin calls are only triggered if the price of the collateral moves beyond a certain threshold.

If the collateral's market value drops significantly during the repo term, the cash lender can issue a variation margin call to request additional collateral to bring the total collateral back up to the agreed margin level.

This process helps protect the lender by ensuring that the value of the collateral aligns with the cash lent, even As its market value changes.

Going back to our previous example, with the $100 million collateral and 2.5% buffer, let's say that after one week, the collateral's market value falls from $100 million to $98 million.

With this drop, the initial margin buffer has effectively shrunk reducing the protection for the lender. To restore the buffer to the originally agreed level, the lender issues a variation margin call requesting additional collateral.

This additional collateral helps maintain the original margin buffer, ensuring the lender remains protected against credit risk throughout the life of the repo transaction.